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Islamic Finance for Investment Managers

Five Steps to Creating a Shariah-Compliant Portfolio
With a Glossary of Islamic Finance Terms

TABLE OF CONTENTS

[03] [04]

Introduction Step One: Finding Your Way Around Shariah Principles

Accounting and Audit Organisation for Islamic Financial Institutions (AAOIFI) Islamic Financial Services Board (IFSB) Islamic Fiqh Academy (IFA)

[05]

Step Two: Choosing What to Offer: Most Common Islamic Products and Transactions
Standard Contracts Shariah-Compliant Communal Investment Vehicles Sukuk Other Instruments Some Primary Islamic Transaction Types

[09]

Step Three: Choosing What to Offer: Shariah View on Conventional Instruments Step Four: The Financial Screening of Conventional Stock: How to Pick Shares for a Shariah-Compliant Portfolio Step Five: Specific Recommendations Regarding Conventional Stock
Purification of Income from Conventional Stock Segregation of Funds/Islamic Windows Workflow The Term Interest

[10]

[12]

[13] [14]

Conclusion Glossary

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Introduction
According to the Global Islamic Finance Report 2011,1 the Islamic finance industry is valued at $1.14 trillion across more than 70 countries and is growing at an annual rate of 10%. It has been performing extremely well since its creation 40 years ago, and its expansion has accelerated in the past few years, within emerging economies around the world but also in non-Muslim majority regions like Europe. Its appeal partly lies in its resilience, due to the fact that it is based in the real economy. The size of the global Muslim population1.3 billion people across more than 50 countries2 contributes to its attractiveness in the eyes of financial institutions, but more recently, firms have also begun to realise that Islamic Finance is not only relevant for Muslim investors, but that it is a type of ethical investment that can appeal to a much broader audience. In fact, many non-Islamic countries have been adapting their financial regulations to enable and promote the adoption of Islamic financial products within their jurisdictions. Islamic Finance has thus become an important sector within the global asset management industry, and one that more and more firms are looking to develop. However, it comes with its own set of unique challenges, from varying regional interpretations of Shariah law to the necessity for investment firms to have their own Shariah advisory board, and the obligatory screening of conventional stocks to ensure acceptability before investing in them for a Shariah-compliant portfolio. Therefore, Islamic investment management today presents great opportunities, but setting up a compliant operation requires considering a number of things. Whether you are contemplating a Shariah compliant offering or just looking into how these principles work, this paper will give you a thorough first overview. Based on an independent research report written by IBS Intelligence (www.ibsintelligence.com) for Advent Software, it explores five steps to help firms get started after which success will depend, as in conventional finance, on each organisations strategy and investment decisions.3 Islamic Finance has become an important sector within the global asset management industry, and one that more and more firms are looking to develop.

1 Global Islamic Finance Report 2011 Regulation in the Islamic financial services Industry, published by BMB Islamic 2 Source: Datavision, by David McCandless 3 This White Paper is based on information provided by IBS Intelligence and other relevant sources.

This communication is provided by Advent Software, Inc. for informational purposes only and should not be construed as, and does not constitute, legal advice on any matter whatsoever discussed herein.

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Step One: Finding Your Way Around Shariah Principles

Islamic finance is finance under Islamic law (or Shariah) principles. The basic sources of Shariah are the Quran and the Sunnah, which are followed by the consensus of the jurists and interpreters of Islamic law. The main principles of Islamic finance include: The prohibition of taking or receiving interest (riba); Capital must have a social and ethical purpose beyond pure, unfettered return; Investments in businesses dealing with alcohol, gambling, drugs or anything else that Shariah considers unlawful are prohibited; A prohibition on transactions involving maysir (speculation or gambling); and A prohibition on gharar, or uncertainty about the subject-matter and terms of contractsthis includes a prohibition on selling something that one does not own. Because of the restriction on interest-earning investments, Islamic banks seek to obtain their earnings through profit-sharing investments or fee-based returns. When financing is provided for business purposes, the financier, if he wants to make a legitimate gain under the Shariah, should take part in the risk. If a financier does not take part in the risk, his receipt of any gain over the amount provided is classed as interest.4 Although Islamic banking and finance authorities are attempting to provide a uniform code of standards and practices, the specifics relating to Shariah-compliance can vary between regions and Islamic schools of thought. To ensure local adherence, each financial institution must therefore be guided by its own internal board of Islamic scholars (often assisted by national boards) that advise on the way in which all transactions are to be processed. Moreover, a number of bodies aim to provide standards and references.

Although Islamic banking and finance authorities are attempting to provide a uniform code of standards and practices, the specifics relating to Shariahcompliance can vary between regions and Islamic schools of thought.

Accounting and Audit Organisation for Islamic Financial Institutions (AAOIFI)

The Accounting and Audit Organisation for Islamic Financial Institutions (AAOIFI), established in 1990 in Bahrain, is an autonomous nonfor-profit body that prepares accounting, auditing, governance, ethics and Shariah standards for Islamic financial institutions, with a view to
4 Source: Freshfields Bruckhaus DeringerIslamic Finance: Basic Principles and Structures

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having them globally adopted as international benchmarks for the industry. They are intended to complement existing international accounting standards (lAS), where there are no specific standards to deal with Islamic banking transactions. Bahrain and Sudan now require Islamic banks to comply with AAOIFIs standards, and in the Kingdom of Saudi Arabia and other Muslim majority countries, AAOIFIs standards are being specified as guidelines.

Islamic Financial Services Board (IFSB)

The IFSB, based in Kuala Lumpur (Malaysia), is an organisation intended to develop international regulatory standards to promote the soundness and stability of the Islamic financial services industry. Its main objectives are to promote the development of prudent and transparent Islamic financial services and provide guidance on the effective supervision and regulation of institutions offering Islamic financial products. In December 2005, the IFSB adopted two standardsthe Guiding Principles of Risk Management and the Capital Adequacy Standard which were intended to complement the Basel II accord with provisions specifically designed for Islamic banks.

Islamic Fiqh Academy (IFA)

The Islamic Fiqh Academy (IFA) was established in 1982 in Jeddah by the Organisation of the Islamic Conference. It meets annually to consider topics relevant to modern-day Islamic life including Islamic finance. One of the most important conclusions relating to Islamic banking arose from the 1985 IFA meeting which definitively ruled on what constituted riba, thus ending decades of uncertainty.

Step Two: Choosing What to Offer: Most Common Islamic Products and Transactions
It will be the decision of an individual firm to determine whether comingling of compliant and non-compliant investments is permitted within a portfolio and even whether the institution is prepared to conduct business in (or hold) non-compliant investments at all. A Shariah-compliant portfolio may be made up of: Islamic-based permitted (halal) investments Qualifying conventional securities and cash The Islamic-based permitted investments are covered by a number of standard contract types.

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Standard Contracts
Mutual Investment Contracts The principal transactions within this group are the mudaraba and musharaka. In the mudaraba arrangement, the bank will provide funds to the entrepreneur who will supply labour or expertise. The bank may invest its own funds in which case it is the investor (Rab ul-Mal), or it may act as agent (mudarib) on behalf of other bank clients who wish to invest funds in which case the bank aggregates the investment funds and places them with the entrepreneur. Profits will be shared according to a pre-defined ratio while losses are borne purely by the investor(s). The musharaka is a similar partnership arrangement, but the bank does not act alone in investing in the project. In a musharaka there are other direct investors, which may include the entrepreneurs themselves. Profits are shared according to a pre-agreed ratio, but losses are shared on the pro-rata of the capital investments. This sharing of profits in an agreed ratio enables the bank to take a higher proportion of profits in order that its investment may be returned earlier, enabling the bank to exit the arrangement earlier than other investors. This arrangement (called a diminishing musharaka) can be used by a client to finance the start-up of a business or the purchase of real estate where the banks share of the ownership gradually reduces. The murabaha is the most common Islamic form of financing. In this the bank acquires an asset on behalf of the client, and in turn the client will buy the asset back from the bank over time. Finance Contracts This group of transactions are used by banks to provide assets, or the use of assets, directly to their clients. The most common types are the murabaha (cost plus sale), the ijara (lease), and the salam and Istisnaa forward finance transactions. The murabaha is the most common Islamic form of financing. In this the bank acquires an asset on behalf of the client, and in turn the client will buy the asset back from the bank over time. The client and bank agree at the time of contract on the amount of profit that the bank will make. This contract can be used at a retail level, say to buy a car, or at a corporate level, for example to acquire real estate. In its reverse form murabaha is used as a method of time deposit. In this arrangement, it is the bank that does the buying and the investor that sells. Most commonly the investor buys a stated commodity which is then sold to the bank for selling price plus profit. The banks payment will be deferred for an agreed time. In this way the investor deposits money with the bank which is then repaid plus profit at a given time in the future, avoiding interest. The ijara lease is similar to a conventional lease in form but presents some significant differences. The bank acquires the asset (plane, manu-

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facturing equipment, etc.) and gives the client the right to use the asset (called usufruct) in return for agreed lease payments. Ownership of the asset remains with the bank, which is also responsible for its maintenance. In an ijara wa iktina, payments contain an element of capital repayment so that at the end of the agreed lease period the capital amount is fully repaid and ownership transfers to the client. The salam and Istisnaa contracts are considered exceptions under Shariah because they involve the purchase of something that at the time of the contract does not exist. The existence and possession of the item by the seller is normally a mandatory condition for a contract of sale, but these two types of contracts are for the growth (salam) or manufacture (Istisnaa) of the items. In both of these types of contract the price paid may be less than the current market price. The description, quantity, quality and time and place of delivery must be clearly agreed in the contract. Accessory Contracts This group of contracts are those where the bank acts on a fee-earning basis. Examples of accessory contracts are agency agreements (wakalah) where the bank is appointed agent for the performance of specific duties such as buying or selling shares, or trust agreements (amanah) whereby the bank is appointed trustee and takes on a duty of care, or where it provides a guarantee (kafalah), whereby a third party becomes surety for the payment of debt if unpaid by the person originally liable.

Shariah-Compliant Communal Investment Vehicles

Additionally, there are many Islamic communal investment vehicles such as unit trusts and other Shariah-compliant investment funds, many of which specialise in property investment or other halal purposes. Such funds are structured, priced and traded in generally similar ways as their conventional counterparts. Shariah Equity Funds Shariah equity funds most commonly invest in the shares of listed Islamic companies whose business purposes are of course halal. Conventional listed companies may or may not be included, but if they are they will need to comply with stipulations detailed in this paper. Shariah Real Estate Funds Shariah-compliant investment in real estate funds can often involve investment in leased commercial properties, where the fund leases out property and receives rentmost often through an ijara contract.

There are many Islamic communal investment vehicles such as unit trusts and other Shariah-compliant investment funds, many of which specialise in property investment or other halal purposes.

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Shariah Private Equity or Venture Capital Funds Shariah encourages investment and risk-taking in real economic ventures. Therefore, provided that it is not debt-based and the purpose of the business is Shariah-compliant, venture capital or private equity can come from Shariah funding. Investments may be based on any of the Shariah-compliant contract types, but this must be transparent in the valuation and trading of the fund.

Shariah encourages investment and risk-taking in real economic ventures.

Sukuk
Sukuk are a very popular form of Islamic investment. They are sometimes colloquially referred to as Islamic bonds although they are quite different in many ways. They do however have similar financial characteristics to conventional bondsfunds are invested, a certificate (sukuk, singular: suk meaning certificate) is issued, the investor receives income and at maturity the certificate is redeemed. Under Shariah law, the amount of income should not be guaranteed and neither should the value at maturity. In a typical sukuk structure, a Special Purpose Vehicle (a company specially created for the purpose) will take ownership of an asset. Investors provide funds to the SPV and in return they get sukuk certificates which actually represent ownership of the SPV. The SPV puts the asset to a lawful purpose (for example, developing a port and waterfront residential premises) and in doing so creates profits which are in turn shared with the sukuk holders. At the end of the term the SPV sells the original asset and repays the sukuk holders. The underlying transactions which generate the profits can be based on any combination of the Islamic contract types shown over the page. Sukuk can be held until maturity or can be traded (if permitted) on several of the emerging sukuk markets.

Other Instruments
The world of Islamic finance is a dynamic one in which new instruments or variations are constantly emerging. Some of these instruments can go on to become industry standards, while others may fall out of favour or be criticised by scholars. An investor may encounter various types of certificates other than sukukmudaraba, musharaka, fixed or floating ijaraeach based on one of the Shariah-compliant contract types. Not all certificates are tradable and particularly those that represent a debt will be designated as non-tradable.

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Some Primary Islamic Transaction Types

Instrument
Murabaha

Classification
Asset or a Type of Financing

Brief Description
Cost price (or deposit amount) plus a defined profit that may be repaid on a deferred basis. Can be used either as financing or customer time deposit. On the buy-side have similar financial characteristics to conventional bonds. Often some variation of SPV owning (for the term) the asset that creates the profits. Certificates (sukuk) represent ownership in SPV. One partner invests funds, the other expertise. Profits are shared on an agreed basis, but not losses. Often used where an investor deposits funds with a manager (mudarib) who makes a profit from an acceptable form of investment. Multiple partners invest funds, while a manager provides expertise. Normally, parties share profits on an agreed basis but losses are shared on a pro rata basis. Islamic leasing arrangement. The bank acquires an asset and gives the client the right to use it in return for agreed lease payments. Buyer agrees to the advance purchase of agricultural produce to finance its planting, growing and harvesting. Buyer agrees to the advance purchase of specified goods to finance manufacture or construction.

Sukuk

Communal Investment Vehicle

Mudaraba

Profit Sharing

Musharaka

Profit Sharing

Ijara Salam Istisnaa

Islamic Leasing Agricultural Finance Manufacturing Finance

Step Three: Choosing What to Offer: Shariah View on Conventional Instruments

The prevailing Shariah view is that certain type of stock market investments are acceptable. Equity-Based SecuritiesMay be Acceptable Equity-based securitiesshares in businessesdo not guarantee any return and in fact, the investor has a real chance of loss, so this is in line with Islamic principles. However, for a conventional equity investment to be Shariah-compliant the business must not be one that is engaged in forbidden activities, and the capital structure of the firm must conform to Islamic financial principles. These requirements are further discussed below. Debt-Based SecuritiesUnacceptable Much of the capital markets consist of debt-based securities. Because these types of securities carry a fixed return until maturity, they are inconsistent with Islamic financial principles. Essentially, all government and corporate bonds are seen as interest-based instruments.

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Preferred StocksUnacceptable If the business goes bankrupt, preferred stockholders have priority in getting their money back over ordinary shareholders, which is unacceptable under Shariah. The provision for paying fixed dividends is also unacceptable, so these investments cannot be considered. DerivativesGenerally Unacceptable The arguments regarding the compliance of derivatives are many and complex. Financiers are attempting to create structures that may deliver the characteristics of certain derivative types. However, for the Shariah requirements of investing in real assets (not just money), the price must be certain, delivery must occur and, although there must be an element of risk and no fixed returns, there should be no speculation in the transaction. These all conspire to generally prohibit derivative-type instruments, although in some markets some emerging contract types may be deemed permissible. Similarly for hedge funds, although financiers are trying to replicate the characteristics of hedge funds, the Shariah requirements relating to selling of assets that are not actually owned (short-selling), the requirement that income is obtained from the use of real assets and avoidance of speculation (gharar) would all act as barriers to Shariah compliance.

The prevailing Shari'ah view is that certain type of stock market investments are acceptable.

Step Four: The Financial Screening of Conventional Stock: How to Pick Shares for a Shariah-Compliant Portfolio
As seen above, some conventional equity investments can be owned individually or through collective investment schemes after they have been examined and declared as acceptable (halal). A screening process is carried out to exclude stocks deemed unacceptable (haram). Lists of acceptable stocks are supplied by various index providers, although not all may be universally accepted by Shariah experts. Obviously excluded are stocks in companies that deal with alcohol (and often tobacco), gambling activities, pork and arms manufacturing. Some investors may prefer to avoid investing in airlines, hotels or supermarket chains that serve or sell alcohol, even though this is a minor part of their business. This would, however, result in a much more restricted potential portfolio selection. Therefore, businesses are usually defined by their primary activity. This principle may make a hotel group acceptable, but a brewery unacceptable. There are parallels with ethical investment funds that avoid investing in tobacco companies but may invest in retailers selling cigarettes alongside other items.

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While there is no universal consensus among Shariah scholars on the prohibition of tobacco companies and the defence industry, most boards advise against investment in these activities. Investment in conventional interest-based financial institutions is also non-permissible. Insurance companies are excluded for this reason, and also because the concept of conventional insurance itself is not wholly accepted. Generally, it would be desirable to avoid investing in companies that have any involvement at all with interest (riba) or riba-based banks. However, this would mean the exclusion of virtually all quoted companies, including those that have their stocks traded in the equity markets of Muslim countries. Additionally, most Islamic scholars accept that modern corporate capital structures of conventional corporations inevitably include some debt on the balance sheet and fixed-income liabilities. As a result of this pragmatic thinking, investments in companies that have low interest income and below average debt-to-equity ratios have been declared acceptable by various Shariah advisory boards, often with the provision that profits must be purified (see below). However, Islamic scholars differ in defining an acceptable debt-tocapital ratio. In practice, investors seeking to comply with Shariah principles adopt several criteria: The extent to which a companys income is derived from interest, generally any proportion in excess of 5% being unacceptable; The extent of debt-to-equity finance, a proportion in excess of one-third generally being unacceptable. Positive criteria can also be used to pick acceptable stocks, such as companies with pro-environmental policies or ones that support their communities or provide humanitarian services. A helpful tool is provided by index specialists through widespread screening of conventional stocks listed on major exchanges. The prominent index providers each offer their own Islamic indexes such as the FTSE Shariah Global Equity Index Series, the Dow Jones Islamic Market (DJIM) Indexes, S&P Islamic Indexes and the MSCI Islamic Indexes. Most Islamic scholars accept that modern corporate capital structures of conventional corporations inevitably include some debt on the balance sheet and fixedincome liabilities.

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Step Five: Specific Recommendations Regarding Conventional Stock

When setting up portfolios and workflows, some additional items must be taken into account to preserve Shariah compliance.

Purification of Income from Conventional Stock

While Shariah scholars generally accept investing in conventional companies that incur some income from interest but have acceptable debtto-equity ratios, many do not find it acceptable to profit directly from those haram activities. Instead they require that income from these companies be purified. This purification requires managers to determine what percentage of a companys profit is derived from interest-bearing accounts and other haram activities. That ratio is used to purifyi.e. segregateany profits the shareholder has gained from holding stock in that company (such as dividends and possibly capital gains) and an equivalent amount is then given to charitable organisations through a zakat or charity account. The institutions Shariah Board should advise on the treatment of purification. From a technical standpoint, there are systems that can then automate the calculations.

Segregation of Funds/Islamic Windows

Not all Islamic institutions are solely Shariah-compliant. Some offer mixed conventional and Shariah-compliant investments, where it is important that workflows and the IT systems segregate funds and cash flows so as not to co-mingle Shariah-compliant and non-compliant monies. This requirement can create significant workflow and technology challenges.

Not all Islamic institutions are solely Shariahcompliant. Some offer mixed conventional and Shariahcompliant investments.

Workflow
Workflow is of particular importance because, as mentioned, the internal Shariah advisory board will consider each transaction type and how it is required to be processed. It is essential that any system can replicate this transaction flow each time the transaction is processed.

The Term Interest

In a Shariah-compliant banking system the term interest should never appear. In the case of an institution investing in both Islamic and conventional products, however, there may be a need for a system capable of dealing with the relevant vocabulary of both investment types.

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Conclusion
Financial institutions considering the creation of a Shariah compliant offering must strive to understand and fully integrate the core principles of Islamic finance to their organisation, with the advice and assistance of their Shariah advisory board, and to abide by the locally accepted interpretations of these principles in the markets where they want to sell. This will include choosing which types of products to offer, both Islamic and acceptable conventional products, and ensuring the right screening processes, workflows, purification methods and segregations of monies are in place to ensure compliance of the Islamic investments at all times. Much of the Islamic banking requirements relate to prohibition of interest, the methods of arranging customer lending or financing, the degree of risk or lack of certainty of a transaction, the validity of the sale transaction, or how detailed transaction processing occurs (such as how late or early payments are processed), but ultimately, Shariah compliance is concerned about what an asset is, what it is used for, and its financial constitution. While achieving Shariah compliance involves significant effort and expense, the dramatic growth in these vehicles may well justify such an investment in future. With the continued development of many emerging markets with a dominant Muslim population, in addition to Islamic products potential appeal for non-Muslim investors in search of ethical products, this investment types 10% annual growth is indeed expected to continue over the next several years. Moreover, international bodies are continuously working towards greater harmonization of international standards, with the increased participation of leading financial services jurisdictions such as Luxembourg or Singapore. The more standardization the industry can develop, the more exportable and replicable the products will be, enabling Islamic financial institutions to harness the benefits of their initial investments to achieve compliance.

Ultimately, Shariah compliance is concerned about what an asset is, what it is used for, and its financial constitution.

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Glossary
The source for all definitions in this glossary is the Institute of Islamic Banking and Insurance. More definitions, and more detail on some of the definitions provided here, can be found at: www.islamicbanking.com Amanah: Trust (Lit.: reliability, trustworthiness, loyalty, honesty). Technically, an important value of Islamic society in mutual dealings; it also refers to deposits in trust. A person may hold property in trust for another, it entails the absence of any liability for loss, except for breach of duty. By extension, the term can also be used to describe different financial or commercial activities such as deposit taking, custody or goods on consignment. Deposits in current accounts (usually noninterest bearing) with Islamic banks are regarded as Amanah. If the bank obtains authority to use the funds in the current accounts to invest in its business, Amanah transforms into a loan from the depositor to the bank and the bank is liable to repay the full amount in the current account, irrespective of profit or loss made by the bank. Arbun: A non-refundable down payment or deposit paid by a buyer for the right to purchase goods at a certain time and certain price in future; if the right is exercised, it becomes part of the purchase price. If the buyer does not complete the purchase or backs out for any reason, the seller has the option to forfeit the deposit. Also known as Urboun and Bai al-Arbun. Diminishing musharaka: (also see Musharakah) A form of Musharakah allowed as a financing mode by Shariah scholars in recent years. An agreement that combines the concept of partnership as in Musharakah to invest in a joint asset and leasing. It allows equity participation by a bank and a customer in an asset and provides a method through which the bank keeps on reducing its equity in the project and ultimately transfers the ownership of the asset to the customer. This involves the customer simultaneously purchasing the banks equity in the form of unit shares, progressively reducing it until the bank is left with no equity left and thus ceases to be a partner. Until such time, the bank leases its share to the customer who pays a rental to the bank for the use and enjoyment of the banks equity share. Islamic banks use this mode widely for financing home purchases, commonly known as Islamic mortgages. Gharar: Several definitions are given for Gharar. For the complete list, please see http://www.islamic-banking.com/glossary_G.aspx. For the purposes of this paper, Gharar can be defined as follows: Uncertainty in a contract of exchange as to the existence of the subject matter of the contract and deliverability, quantity or quality of the subject matter. It also involves contractual ambiguity as to the consideration and the

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terms of the contract. Such ambiguity will render most contracts invalid. The root Gharar denotes deception; an exchange in which there is an element of deception either through ignorance of the goods, the price, or through faulty description of the goods. Thus, one or both parties stand to be deceived through ignorance of an essential element of exchange. Gambling is a form of gharar because the gambler is ignorant of the result of the gamble. Speculative risk-taking in commerce, which involves the investment of assets, skills and labor, is not considered similar to gambling. This is because the buyer is engaged in a transaction aimed at making profit through trading and not through dishonest appropriation of the property of others. The prohibition on gharar is often used as the grounds for criticism of conventional financial practices such as short selling, speculation and derivatives. Halal: That which is permissible by the Shariah, valid earnings. The concept of halal has spiritual overtones. Muslims believe that all things have been provided by God, and the benefits derived from them, are essentially for the use of mankind, and so are permissible except what is expressly prohibited in the Quran or the Sunnah. It also refers to activities, contracts and transactions as well as earnings. When guidance is not clearly given in the Quran there are several other sources of law, for example, guidance can be sought from Fiqh, which means understanding and is the science of jurisprudence: the science of human intelligence, debate and discussion. The concept of halal is one of the distinctive features of Islamic economics vis-a-vis Western economics where no such concept exists. In Western economics, all activities are judged on the touchstone of economic utility. In Islamic economics, other factors, mostly ethical and moral are also involved. An activity may be economically sound but may not be allowed in the Islamic society if it is not permitted by the Shariah. Haram: Unlawful in Islam. Activities which are explicitly prohibited by the Quran or the Sunnah. The prohibitions also includes professions, contracts and transactions as well as earnings. Ijara: Technically, sale of a definite usufruct in exchange for a definite reward. Commonly used for wages, it also refers to a contract of land lease at a fixed rent payable in cash. More definitions are available at http://www.islamic-banking.com/glossary_I.aspx Ijara wa iktina: Lease agreement with option to acquire the leased asset at the end of the lease period. Often used in the context of home purchasing. It extends the concept of Ijarah to a hire and purchase agreement. Istisnaa: A contract of sale of specified goods that have to be manufactured before delivery is possible. A forward sale; literal meaning, to manufacture or build. Under the Shariah, a sale cannot normally be

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effected unless the goods are in existence at the time of the contract however, it is argued that it is justified in the case of istisnaa as the need for the goods are such that they cannot be sold until they are manufactured, however the order to manufacture is demonstration of the general need and the availability of the manufactured goods is relatively certain. Kafalah: Surety, an obligation in addition to an existing obligation in respect of a demand for something. Lit: responsibility or suretyship. It is a covenant or pledge given. Legally, a third party becomes surety for the payment of a debt of another. Suretyship in Shariah is the creation of an additional liability with regard to a claim, not to the debt or the assumption only of a liability and not of the debt. A person providing surety or a guarantor is known as Kafil. Islamic banks use Kafalah to issue guarantees for their business customers, for example, the bank may guarantee the customers standing to facilitate any business endeavours that may require such guarantees, or the bank may give a surety to the owner of a ship or the shipping agent, to discharge goods imported by a customer on arrival of the carrying ship, pending receipt of the original shipping documents before the customer can take delivery of the imported goods. Also, known as Kifalah. Maysir: Games of chance or gambling, trying to earn easy money without having to provide equivalent consideration. A prohibited activity, as it is a zero-sum game just transferring the wealth not creating new wealth. One of three fundamental prohibitions in Islamic finance, the other two being riba and gharar. The prohibition on Maysir is often used as the grounds for criticism of conventional financial practices such as speculation, conventional insurance and derivatives. Mudaraba: 1. An investment partnership with profit-loss-sharing implications. 2. A form of business partnership contract in which one party brings capital and the other personal effort to undertake a business enterprise, as manager or entrepreneur. Mudarib: The partner in Mudarabah providing entrepreneurship and management to a partner providing the capital. Murabaha: 1. A contract of sale between a seller and a buyer; the seller sells certain specific goods to the buyer at a cost plus an agreed profit mark-up. The seller must disclose the cost of goods and the profit mark-up. 2. Cost-plus financinga contract sale between the financier or bank and its client for the sale of goods at a price which includes a profit margin agreed by both parties. Musharaka: The literal meaning of Musharakah is sharing, an investment partnership with profit-loss-sharing implications. A musharakah contract is similar to a mudarabah contract, the difference being that in a musharakah all the partners contribute to the capital and share in

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both the profit and the loss. They also have the right, but not the obligation to participate in the management. (more details at http://www.islamic-banking.com/glossary_M.aspx) Rab ul-Mal (also Rab-al-Maal / Rab al-Mal): Owner of capital. In a mudarabah contract the person who invests the capital (the capital owner or financier). Riba: Technically it denotes any increase or addition to capital obtained by the lender as a condition of the loan. In simple terms Riba covers any return on money on money, whether the interest rate is fixed, floating, simple or compounded and at whatever rate which is guaranteed irrespective of the performance of the investment, is considered riba and is so prohibited. Riba, in all forms, is strictly prohibited in Islamic tradition as it is considered an unjust return that leads to unjust enrichment. Commonly understood as interest charged or received on lending though the legal definition goes beyond just interest. It is one of the three fundamental prohibitions in Islamic finance, the other two being gharar and maysir. (more details and specific forms of riba are defined at http://www.islamic-banking.com/ glossary_R.aspx) Salam: An advance purchase or a type of sale in which the full price of the goods is paid in advance and the goods are delivered later at a specified date in the future. It is similar to a modern forward sale contract. Under Shariah, a sale cannot normally be effected unless the goods are in existence at the time of the contract. However, this type of sale is an exception provided the goods are defined and the time of delivery is fixed. The exception was practiced in the early days of Islam to meet the needs of the small farmers in Arabia who required money to grow their crops and to feed their family until the time the crop could be harvested and sold; owing to the prohibition of riba they could not borrow money on interest; they were allowed to sell the agricultural produce in advance of cultivation for delivery later and take payment in advance. The object of the sale must be tangible goods that can be defined as to quantity, quality and workmanship. The mode of financing is often applied in the agricultural sector, where Islamic bank advances money without interest for various inputs and in exchange receives a share of the produce, which it then sells after delivery. To hedge against fall in prices, the bank can also sell the goods to a third party before delivery through a parallel contract of Salam. Shariah: Often referred to as Islamic law. Refers to the rulings contained in and derived from the Quran and the Sunnah. These cover every action performed by an individual or a society. It is primarily concerned with a set of values that are essential to Islam and the best manner of their protection. The essential values of the Shariah include

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those of faith, life, intellect, lineage, property, protection of honour, fulfilment of contracts, preservation of ties of kinship, honouring the rights of ones neighbour in so far as the affairs of this world are concerned, and the love of God, sincerity, trustworthiness and moral purity, in relationship to the hereafter. The method of finding solutions to new issues in the light of the goals and principles of Islam are Ijtihad (independent reasoning), Ijma (consensus) and Qiyas (analogy), these solutions are all upheld and supported by the Quran and the Sunnah. Sukuk: A financial certificate. Similar characteristics to that of a conventional bond with the key difference being that they are assets backed; sukuk represent proportionate beneficial ownership in the underlying tangible asset(s) of particular projects or investment activity. Wakalah (also wakala / al-wakala / wakalah bil ajr): Agency. A contract of agency in which one party appoints another party to perform a certain task on its behalf, usually for payment a fee or commission. An agency arrangement without provision for payment of a fee cannot be considered irrevocable, thus allowing an agent the right to terminate the agency at any time. Zakat (also zakah): Lit: blessing, purification, increase or cultivation of good deeds. An obligatory contribution or tax prescribed by Islam on all Muslim persons having wealth above an exemption limit at a rate fixed by the Shariah. Zakat is the third pillar of Islam. According to the Islamic belief Zakat purifies wealth and souls. The objective is to take away a part of the wealth of the well-to-do and pay it to the Islamic state and/or distribute it among the poor and needy.

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